Small Cap Value Report (Wed 01 Dec 2021) - STVG, PDG, VLG, REDD, D4T4

Good morning! It's Jack & Roland here with the SCVR for Wednesday.

Agenda -

Jack's section:

Stv (LON:STVG) - strong end to the year, with full year total advertising revenue expected to be up by 22%-24% year-on-year. Modestly valued, growing, with a good market position, but the financial risks of its pension scheme continue to dominate the investment case.

Venture Life (LON:VLG) - collapse in share price this morning (now 27% down) due to multiple ongoing challenges. Revenue and adjusted EBITDA marked down for FY21 and FY22. Sentiment and confidence has been smashed here; management does not appear to be executing so I'm not really tempted regardless of valuation.

D4t4 Solutions (LON:D4T4) - the company is winning contracts and operates in some attractive growth markets, but the valuation is high and a potential derating is a concern. The business itself looks interesting, so perhaps one to put on the watchlist in case it's ever on sale.

Roland's section:

Pendragon (LON:PDG) - the second profit upgrade in two months from this car dealership group. Turnaround efforts have provided a tailwind to the extraordinary market conditions we’ve seen. But how long can it last? I think there might be better choices elsewhere in this sector.

Redde Northgate (LON:REDD) - a strong set of figures from the vehicle hire and accident management group, which has also benefited from shortages of new vehicles. However, I have concerns about the trajectory of growth as post-merger benefits and pandemic effects ease.

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Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review trading updates & results of the day and offer our opinions on them as possible candidates for further research if they interest you. Our opinions will sometimes turn out to be right, and sometimes wrong, because it's anybody's guess what direction market sentiment will take & nobody can predict the future with certainty. We are analysing the company fundamentals, not trying to predict market sentiment.

We stick to companies that have issued news on the day, with market caps up to about £700m. We avoid the smallest, and most speculative companies, and also avoid a few specialist sectors (e.g. natural resources, pharma/biotech).

A key assumption is that readers DYOR (do your own research), and make your own investment decisions. Reader comments are welcomed - please be civil, rational, and include the company name/ticker, otherwise people won't necessarily know what company you are referring to.

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Jack’s section

Stv (LON:STVG)

Share price: 335p (pre-open)

Shares in issue: 46,722,499

Market cap: £156.5m

We’ve covered STV before - it’s got a great (somewhat unique) market position as Scotland’s most popular terrestrial TV channel, with a growing digital back catalogue. It’s similar to Itv (LON:ITV) but the only thing ruling it out for me recently has been the state of the balance sheet, and more specifically, the pension deficit.

A shame that such a promising company is compromised by a negative net asset value. The largest line item in Liabilities is this pension deficit, which has recently reduced from a £127m pre-tax deficit to a £116m pre-tax deficit on a triennial actuarial basis. The 2021 deficit recovery payments will total some £9.3m, with annual payments then increasing at the rate of 2% per annum over the term of the recovery plans. This is less than the previous plan but still very significant.

If meaningful progress can be made on the pension deficit, then the trends are otherwise positive. Trading is good and the company is modestly valued, reflecting the financial risk (note though, that an improving pension deficit can be a strong catalyst for equity).

The group’s broadcast channel, accessible free-to-air on all the main TV platforms in Scotland, reaches 3.2 million viewers each month. STV Player is the UK’s fastest-growing broadcaster streaming service, with over 3,000 hours of drama, sport and factual entertainment series. This part of the company has grown significantly over the past year.

STV Studios is Scotland’s biggest production company, with commissions spanning BBC One and Two, ITV, Channel 4, Channel 5, BBC Scotland, Discovery, VH1/MTV and Sky One.

Q4 update

Previous guidance that STV Studios is on track for its best ever financial performance in 2021, with full year revenue of £20-25m, is reconfirmed today.

Total advertising revenue for the full year is expected to be up by 22%-24% year-on-year, helped by a stronger than expected final quarter.

Within that STV expects regional advertising to finish the year strongly, up around 20% for 2021, and 15% ahead of 2019. VOD (video on demand) advertising on the STV Player is expected to be up 35-40% for the full year, over 50% ahead of 2019 levels.

Q4 advertising has shown continued good momentum, despite strong comparators from Q4 2020, and is expected to deliver TAR growth of +13-15%, with regional advertising up a further 15-20% and VOD up around 10%. Within that October TAR was +15%, November +20% and December is expected to be up 5-10%.

There’s also good news in the STV Growth Fund, which will be increased from £20m to £30m in 2022. ‘Since launch in 2018, the STV Growth Fund has allocated £15.7m across more than 700 deals with Scottish SMEs, attracting over 300 new advertisers to television.’

STV Chief Executive Simon Pitts said:

The speed and scale of the advertising recovery in 2021 has far exceeded our expectations and underlines the enduring power and relevance of high-quality video advertising.

2021 will deliver STV's highest ever advertising revenues, with brands choosing broadcast and video on demand advertising to boost their post-Covid recovery due to its unrivalled levels of trust, brand safety and value.

Conclusion

I like STV as it’s something of a unique asset with a strong market position and an expanding content catalogue. It’s modestly valued and growing, too. The pension deficit is a big risk though - rising interest rates help here, as the impact on the discount rate used to value these funds tends to have a more significant downwards impact on scheme liabilities than it does on assets.

Investors rarely have access to all relevant information, and pension schemes are a good case in point. It can be very hard (ie. impossible) to get granular detail on the composition of these schemes. But should the funding situation improve, that can be a material catalyst for equity value. This situation makes the group very risky though, and probably uninvestable for some investors.

In my view, it is not particularly prudent to be paying out dividends to shareholders when pension scheme contributions are set at £9.2m and increasing at 2% each year thereafter.

This (big) point aside, the group is trading well, and I do like it. Perhaps time spent delving into the pension scheme will pay off but in my experience shareholders get limited information here.

Here’s the impact in FY20:

The 2020 accounting deficit was £70.3m, so I wonder why the updated actuarial valuation comes out at a notably larger deficit of £117m. The auditors didn’t find the scheme valuations to be materially misstated in FY20 but did note:

All actuarial assumptions fell within our observable/expected range based on the nature of the schemes and scheme experience, albeit, mortality rates continue to be at the lower, more optimistic end of the range.

Looking through Note 26 of the FY20 annual report, we see that a decrease by one year in the rate of mortality would decrease scheme liabilities by 4%, so presumably an increase would lead to a 4% increase in liabilities. By the sounds of it, if we wanted the group’s assumptions to be completely in line with the market, something like this would need to happen but it’s hard to quantify.

For all the group’s good work, taking a view on the financial risks of the group’s pension scheme remains the most important factor here.

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Venture Life (LON:VLG)

Share price: 34.83p (-27.43%)

Shares in issue: 125,831,530

Market cap: £43.8m

A notable decline in value here, commiserations to holders. The share price is right back to where it started before its 2020 rise, and is now comfortably below its 2016 IPO price.

This is a short update that raises more questions than answers. A c24% drop in share price either reflects the current risk-off sentiment or possibly a longer-running exasperation with the management team here.

Trading update

In the Interim Results, reference was made to some of the challenges that the Group had been experiencing. These challenges persist; the ongoing impact of COVID continues to affect confidence across many markets, with some customers choosing to reduce inventory, rather than place new orders, and also to delay orders at short notice.

I wonder which products are referenced here? I don’t see why customer and consumer confidence would affect sales in Dentyl mouthwash, for example. That’s exactly why this kind of consumer defensive company is supposed to be so valuable.

The industry continues to experience increased input prices, not all of which can be passed on to customers immediately, along with supply shortages for some components, and the well publicised issues with truck availability / pricing have created additional uncertainty surrounding logistics.

Again, you would hope brand owners had some degree of pricing power when it comes to passing along input cost pressures. This is an area affecting many businesses, but I would suggest that other management teams have perhaps done better at navigating these challenges.

The Company's Chinese partner has continued to disappoint against expected levels of sales and, as a result, the Company is exploring alternative opportunities to ensure that sales in China are maximised in 2022 and beyond.

The Company continues to await the publication of the peer-reviewed in vivo study carried out by Cardiff University, which was completed in April this year... Further, the Company notes the recent announcement made by Salisbury Hospital regarding specific mouth care guidance for patients with Covid-19. As well as regular toothbrushing, the guidance also suggests that both Dentyl Dual Action and Dentyl Fresh Protect should be used. The Company understands this guidance was based on research conducted by Doctors at Salisbury Hospital, as well as the in-vitro (lab based) results widely published by Cardiff University in November 2020.

This always struck me as slightly opportunistic. Was mouthwash ever going to move the dial when it comes to combating a global pandemic? I’d rather hear about why Venture Life’s products position it as an attractive consumer defensive company with long term organic growth potential, not how it miraculously might be the last line of defence against Covid according to Cardiff University.

Jerry Randall, CEO of Venture Life, comments:

As we highlighted in September, and has been reported widely in the media, trading conditions at this time are challenging for many businesses. More pleasingly, we are beginning to see positive traction in passing some price increases onto customers, although this will take 12 months to fully wash through.

… The challenging trading conditions mean that we are now more cautious about the levels of growth that we expect in the immediate future, but we are confident that our growing revenues will deliver growing profitability.

Conclusion

There’s more than the usual amount of things not quite working out here, so I’m skeptical. Supply chain disruption I understand and, while a delayed study might be frustrating, were Covid-related mouthwash sales ever going to be a source of enduring value for shareholders?

The chair and CFO are both leaving the company, which seems quite sudden. While chairperson Lynn Drummond has been on the board since 2013, the CFO only joined in May 2019.

FY22 revenue guidance is also being marked down by Cenkos even though the company ‘continues to look to 2022 with confidence’. Due to the leverage in the business, Cenkos is reducing adjusted EBITDA by 23% in FY21 and 27% in FY22.

The group says its acquisitions are integrating as planned and it’s getting to grips with passing on price increases, although the full effects of this will not be felt for another 12 months.

But the direction of travel here is all wrong, and sentiment and confidence looks shot. In fact, if you want a snapshot of that sentiment, see mojo’s comment below.

In the short term, these are what drive share prices so I can’t see a recovery for at least a couple of months. I might be wrong on that, but I suspect investors will have some time to analyse the group’s position and revised prospects.

The group does have a large net cash position of around £35m, so it’s not in terminal danger. A total collapse in sentiment can lead to deep value opportunities, but this does not strike me as an enticing prospect. There are quite a few plates spinning here, and they look rather wobbly at that.

Edit: the group did have a large net cash position - at the end of FY20. Since spent, with H1 21 net debt of c£7m.

Needless to say, directors ‘are pleased with the progress’ and ‘see many reasons to be optimistic’...

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D4t4 Solutions (LON:D4T4)

Share price: 315p (-4.55%)

Shares in issue: 40,257,058

Market cap: £126.8m

D4T4 has many of the characteristics you might expect of a high quality software company:

• Net cash position,
• Steadily increasing revenues,
• Double digit profit margins,
• Strong cash conversion and free cash flows,
• A high Quality Rank (78 in this instance), and
• Premium multiples-based valuations.

In terms of its products:

Celebrus CDP automatically captures, contextualises, and activates user-based behavioural data in real-time across all digital channels. Through behavioural biometrics and analytics, Celebrus FDP helps companies prevent fraud before it happens. Celebrus CDM provides an enterprise platform that automates the integration and transformation of customer data from all relevant data sources, whether on-premises or cloud, to deliver customer and regulatory analytics.

The recurring question with these types of companies is whether or not the high multiples paid today are in fact cheap after accounting for the group’s medium to long term growth prospects and potential operational leverage.

There are also the shorter term prospects to consider, primarily with the risk of a derating should forecast growth be pushed back. This has happened to Eleco (LON:ELCO) for example, which has seen its FY21 and FY22 EPS forecasts nudged down as it transitions towards recurring revenue spread over a longer period of time.

Half year results

Highlights:

• Revenue +49% to £7.6m,
• Annual recurring revenue ("ARR") stable at £10.4m (H1 FY21: £10.1m, FY21: £10.6m)*
• Gross margin improved from 48.6% to 53.2%,
• Adjusted PBT up from a loss of £0.6m to £0.1m,
• Adjusted EPS up from loss of -2.38p to 0.22p,
• Cash up from £12.1m to £16.1m with no debt,
• Interim dividend +4.9% to 0.85p.

The fall in ARR was due to the loss of an airline industry customer affected by the pandemic and ‘conversations continue with that customer to bring them back into the fold’.

A period of change, according to the group, positioning it for ‘accelerated growth in the coming years’. The strategy remains based around the following:

• Increase revenues from the Celebrus family of products,
• continue the transition to an ARR model and grow ARR significantly in the coming years,
• invest in the next generation of Celebrus products; and
• drive international expansion and gain market share in key markets.

Contract wins in the period include a new multi-year contract win with an existing Norwegian banking customer, as well as contract upgrades with a European based retailer, and a US based top 10 global insurance provider. There are more, across both CDP and CDM.

Product innovation - Celebrus Customer Data Platform (CDP)

In May 2021, D4t4 launched Celebrus CDP version 9.4 with new features which we believe deliver unrivalled identity capabilities to the marketplace. These now include the world's only first-party real-time Identity Graph as well as a Profile Builder. These enable the "collect once, use many" data mantra of Celebrus CDP and enable the efficient activation of customer data in downstream applications.

… The Group believes that no other industry solution overcomes the challenges of identity, compliance, and activation to deliver genuine, individual-level data in the way that Celebrus CDP does.

D4T4 also launched its Celebrus Fraud Data Platform (FDP) in June 2021, which captures and contextualises data for real time fraud detection. The group says this is ‘the result of two years' design and development work and significant R&D investment by the Group into the large and growing market of fraud protection software, estimated to be worth over $12 billion per annum.’

International expansion - a new office opened in Australia enabling the development of local relationships in the Asia-Pac region with global partners. D4t4 expects to add further headcount in Australia, on top of new headcount recently added in North Carolina, United States and Chennai, India.

Acquisition - In August 2021, the group acquired Prickly Cactus, a UK data and analytics consultancy.

Current trading and outlook:

The Board remains confident in delivering a strong finish to FY22 with second half prospects well underpinned by good visibility on new contracts expected to be signed in H2, and a significant pipeline of business in negotiation with new and existing clients.

D4t4 continues to invest in its international markets, product innovation and strengthening partner relationships in line with the substantial market opportunity.

Conclusion

I do struggle with the valuations of some of these software companies, as conservatively financed and as large as their addressable markets can be.

A risk is a more general cooling on tech sentiment or a rotation into value - on a forecast PER of 38.4x, what’s to stop D4T4 from derating to 25x-30x and trading at those levels for a few years? It would still be a conventionally ‘expensive’ multiple. This hasn’t happened so far, and the five-year share price performance is good.

Cash collection has been impressive but ARR growth has stalled due to the (temporary?) loss of an airline customer. I’d want to see more growth given the high PER.

The company does seem to have attractive products that are winning contracts in large markets, so if it scales up then profit growth could accelerate. But with no specific knowledge of just why its products warrant such a high rating, I’d still want a cheaper multiple before considering it.

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Roland’s section

Pendragon (LON:PDG)

Share price: 19.8p (08:15)

Shares in issue: 1.4bn

Market cap: £265m

Trading update

Strong performance to date in Q4. Further upgrade to full-year underlying PBT expectation

It’s no secret that the big car dealers are generating exceptional profits at the moment. A shortage of new cars has enabled dealers to expand their profit margins on the cars they do sell.

Guidance upgraded: The impact of this is remarkable. Today we have Pendragon - whose brands include Evans Halshaw and Stratstone - upgrading its profit forecasts for the second time in two months (kudos for such clear guidance):

• October 7: pre-tax profit guidance upgraded from £55m-£60m to “approximately £70.0m”
• 1 December: pre-tax profit profit guidance increased “to approximately £80m”

In less than two months’ trading, Pendragon’s estimates of its profitability for the final quarter of the year have increased by £10m, or nearly 15%.

Is the shortfall easing? What caught my attention in today’s update was a possible hint that supply problems might be starting to ease.

Pendragon says that the main reason for today’s upgrade was that the supply shortfall (versus orders) of new cars in October and November was lower than expected. This enabled the company to deliver more cars than planned during the months, bringing forward revenue and profits.

Pricing also remains strong - no figures are given, but management says that gross profit per unit remains “strong”.

Similarly, used cars are selling well and enjoying “improved gross profit per unit”.

Outlook: Management remains cautious about further disruption from Covid-19 and supply chain issues. But with one month of the year remaining, the firm is confident it can hit today’s upgraded profit forecasts.

Is Pendragon’s turnaround complete? The global chip shortage and resulting restriction on new car production has left the car dealership group enjoying exceptional profit margins. For how much longer, we don’t know.

Despite this, investors are still keen to put money into this sector. Marshall Motors received a generous (in my view) takeover offer earlier this week. Shares in rival Vertu Motors (I hold) are trading at post-Brexit highs.

However, Pendragon shareholders have not enjoyed such big gains:

One reason for Pendragon’s more lacklustre share price performance is that the company was in turnaround mode prior to the pandemic.

A new strategy unveiled in 2020 has streamlined the group’s dealership network and improved its online capabilities and used car operations. These changes have provided an additional tailwind to the market forces we’ve seen at work over the last 12 months.

One notable impact of this fortuitous timing is that Pendragon has been able to clear its financial debt. September’s interim results showed adjusted net cash of £9.5m, compared to a net debt figure of £100m at the end of 2020. (This adjusted figure excludes lease liabilities and vehicle stocking facilities, hence why it doesn’t match the figure shown on the StockReport.)

My view: Based on today’s upgrade, I estimate Pendragon shares may now be trading on a 2021 forecast P/E of 4.5x. That’s obviously extremely cheap, but I see this as a reminder of what’s likely to happen next.

At some point, the supply of new cars will once again match or exceed demand. I’d guess this will be in 2022. When this happens I expect competition for customers to drive margins down to more normal levels. In my view, profits at the big dealership groups could fall by 25%-50%.

Pendragon seems to have made good progress with its turnaround. The firm has been able to strengthen its balance sheet without requiring a rights issue. But shareholders haven’t received a dividend since 2018 and the stock is still well below historic highs. I think there’s a risk this could be as good as it gets for a little while.

If I was buying shares in this sector today, I’d choose Vertu or perhaps Motorpoint, both of which have more consistent track records. Personally, I can’t see much reason to buy Pendragon shares today.

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Redde Northgate (LON:REDD)

Share price: 421p (+7% at 08:40)

Shares in issue: 246,091,423

Market cap: £1.0bn

Interim results

This van hire and vehicle repair/credit hire group is a little above our normal size limit, but I’m going to cover it in response to a reader request. I know that Redde Northgate has been a regular feature in the SCVR over the last couple of years.

Indeed, shareholders who bought during the early part of the pandemic (or even before) have enjoyed a multibagger. The shares are now above pre-pandemic levels:

But they could still offer decent value based on current forecasts:

Stockopedia’s algorithms seem to like the shares too, awarding them Super Stock status and a StockRank of 98.

Let’s see if today’s results have changed the picture at all for this “mobility solutions provider” - a combined vehicle hire, fleet management, repair, and claims management operation.

Half-year results highlights: At first glance the numbers certainly look strong,

I think it’s worth remembering that this business doesn’t have much of a track record to provide context for these numbers. The merger between Northgate and Redde only competed on 21 February 2020, after which the business was plunged straight into the pandemic.

My impression is that some of the gains seen over the last 18 months have been generated by one-off cost-saving measures and tailwinds linked to new vehicle supply restrictions. Even so, these do look like a strong set of figures to me.

Redde Northgate’s quality metrics also seem to be holding up, at least on an adjusted basis:

For what it’s worth, my calculations show ROCE of 9% on a trailing 12-month basis. That’s not bad for a business of this kind, in my view.

Balance sheet: The main risks I’m looking for here are debt and cash generation.

Redde Northgate’s rental fleet of 120,000 vehicles requires debt financing and regular capex. The free cash outflow seen over the half year reflects £189m of vehicle purchases (1H21: £138m). As far as I can tell, this was split roughly equally between replacement capex and growth capex.

I expect to see positive free cash flow for the full year, albeit at a lower level than last year. In the meantime, I am prepared to accept the company’s steady state cash generation figure as evidence that underlying cash generation is continuing to improve.

The company says that its net debt excluding lease liabilities is £470m, which is equivalent to 1.5x EBITDA. That’s stable and within the company’s target range of 1x-2x. I’d argue that 1.5x is probably high enough, especially given the potential pressure on rental margins when the vehicle supply chain normalises.

Even so, I don’t see any cause for concern with REDD’s balance sheet at this time.

Business update: Management commentary seems fairly encouraging. Accident and incident numbers are now said to be at 90% of pre-Covid levels. This is helping the Redde business return to normal.

Looking ahead, Redde has won multi-year contracts with insurers including Tesco and Admiral that are said to have a lifetime value of over £200m. These deals are expected to contribute to results from FY23.

In the meantime, the Northgate van hire business is benefiting from good demand and strong pricing, due to the constraints on new vehicle supply. This is also boosting margins on used vehicle sales, albeit on lower volumes than normal.

Helpfully, the company provides a snapshot showing how revenue and profit are distributed across the business:

Stripping out the segmental margins some marked differences:

• Rental margin: 17.5% (1H21: 12.0%)
• Vehicle sales margin: 30% (1H21: 14.4%)
• Claims and services margin: 5.7% (1H21: 1.0%)

Profits from rental and disposal contributed 89% of underlying operating profit during the first half.

It’s worth mentioning that the rental business has also benefited from the supply chain problems that are boosting profits for car dealers. According to management, margins on the UK rental business rose from 12.7% to 17.6% during the first half, thanks in part to “tight controls over customer pricing”.

I wonder how much of this margin increase will be sustainable when supply chain conditions normalise. Northgate’s hire business has good scale in the UK market, but it’s a competitive sector and there are other larger players, too.

My view: I have to admit I’ve always been sceptical about the combination between Redde and Northgate. In my view, Northgate shareholders got the worse part of this deal. Today’s results haven’t really changed this view.

From my perspective, Northgate’s van hire business has good scale and decent margins. Continued growth should be supported by structural trends in vehicle ownership and fleet management.

In contrast, Redde’s core accident management business is low margin and could be subject to regulatory risk.

However, I accept that the combined group does seem to be trading well at the moment. The balance sheet isn’t too bad and cash generation seems acceptable.

Looking ahead, broker forecasts suggest earnings revenue and earnings growth are likely to slow in FY23.

Despite this, I don’t see any reason why this business shouldn’t be able to continue delivering incremental growth for the foreseeable future.

Due to the level of leverage and the relatively modest profitability of this business, I don’t think the shares deserve a high rating. The stock’s current valuation on c.10x forecast earnings looks reasonable to me and may offer some further upside. The dividend yield of 4.5% is certainly attractive.

However, I’m not convinced the shares are an obvious bargain, as they probably were 12 months ago.

If I owned REDD shares today, I’d probably continue to hold. But as a potential investor, I intend to stay on the sidelines to see how this business matures as pandemic conditions ease.